The Initial Public Offering (IPO) can be a lucrative gravy train for the chosen few consisting of the company’s founder(s) and management team, the venture capital firms, the investment banks, and the best clients of the investments banks. The general public investors are last in line and may carry substantially more risk relative to the potential reward compared to the chosen few, or “insiders”. But, to be fair, the venture capitalists absorb all of the initial risk for a new company’s formation by fronting millions of dollars to fuel the early growth phase. Millions of dollars can be lost if the business idea flops, but millions or billions can be made if the business idea takes off.

In the case where a business concept performs well, the insiders are well positioned and insulated to make extraordinary amounts of money. For simplicity, lets use an example that includes one insider for each insider category and make simple assumptions as to how shares of the company are priced and allocated. In reality, there are many insiders serving each function. Lets say the venture capital firm invests $100 million in a company. At the time of the investment the firm agrees to issue 50 million private shares that represent that $100 million initial investment. This translates to just $2 per share. Now, lets say the company wants to give the founder of the company 15 million shares and the recently hired CEO 5 million shares. The venture capital firm now has only 30 million shares but is betting that when the company goes public the share price will be much higher that $2 dollars per share so that they can cover their initial investment in the company, the founder, and executive management team.

Before a company can go public it must hire an investment bank that will handle all the underwriting of the stock and create demand for the stock when it goes public. The investment bank rounds up a few of its premier clients and generates interest and commitments from the clients. The investment bank also estimates the projected value of the company’s stock price and market capital to set an offering price on the day the company goes public. Meanwhile, the media and press is leveraged (owned by powerful financial institutions and linked to the “inside” community) to hype up the company and build public (often the suckers) excitement around the initial public offering. The investment banks receive handsome compensation in the millions for underwriting the company’s stock and setting the initial public offering price.

Now, lets see how insiders get rich. Lets say the company decides to offer to the public 7 million shares. And lets say 5 million shares come from the venture capital firms share, one and a half million from the founder, and half a million from the CEO. That leaves the venture capital firm with 25 million private shares, the founder with 13.5 million private shares, and the CEO with 4.5 million private shares. Remember, these private shares only have an exercise price or cost of $2 dollars per share. Now, lets say the investment bank decides to set the initial offering price for the stock to be $20 per share to the public. Because the company is only floating (offering to the public) a small portion (7 million) of the total company’s shares (50 million) to the public, there is greater demand for these shares. As we all know, a smaller supply combined with media hype drives up the price. Now, lets say the price of the stock on the initial day of trading jumps up to $30 dollars or 50% of the initial stock price. Such jumps on the initial day of trading is not unusual if the company offers a small float and has enjoyed great media hype.

Based on the above scenario, the following describes how rich the insiders got. First, “the company” raised $140 million by selling 7 million shares to the public at $20 dollars per shares. But, the company pays $30 million to the investment bank for underwriting fees and other services. Therefore, the net proceeds to “the company” amount to just $110 million. The remaining private shares held by the venture capital firm, the founder, and the CEO of 43 million at $30 dollars per share are now worth almost $1.3 billion dollars. If the venture capital firm were to cash out all their 25 million private shares at $30 dollars per share they would haul in $750 million. Not bad considering they only invested $100 million in the company. If the founder were to sell all his shares he would pocket $378 million net after deducting the $2 dollar per private share cost. And the CEO would cash in $126 million net. Keep in mind the CEO also probably earns an annual salary and bonus of $500,000 or more. So, in this example, the company brought in $110 million to fuel the future growth of the company, but the insiders hauled in potential value of $1.3 billion for their own pocket books and the investment banks earned a measly $30 million.

There are many more complexities to discuss in the scheme above, but the overall point is still valid. Initial public offerings, in many cases, are not primarily undertaken to raise capital for the company, rather, they are undertaken to vastly increase the bank accounts of the insiders. It is the insiders that can reap the greatest rewards from an IPO, not the company. And the company is what all the outside investors pay for when they buy shares on the public stock exchange. And when that company ends up being simply a media hyped shell game and the stock price plummets to $7 dollars per share, it is the outsiders that directly paid the insiders for their outrageous wealth accumulation. But the insiders already have all the money once the public becomes aware that the company was nothing more than a hyped up Ponzi scheme or fraud. This is what happened during the Dot Com bomb. This is what happened with Enron. This is what happened during the housing derivative scam. And this is what I believe will happen with the Social Networking/Media sector.Don’t invest in Facebook, Twitter, or any of the other company’s in this hyped up hollow sector, unless you are on the inside IPO gravy train.

6 Responses to Inside the IPO Gravy Train

Wall Street is not going to like you. They need these glorified sexy stocks to bring in new money to the big casino. I got taken to the cleaners in the late 1990s when Dell plummeted despite great results, they just were not great enough. And my pension furhter crashed and burned around 40% when Janus fund imploded despite a five star Morningstar rating because it held the big prize back then called Enron, and Enron imploded. I would approach all of these companies with big caution. Make sure to read what your mutual funds are holding too. That was my mistake, trusting too much in the system.

LOL…then you really have a reason to be p.o..ed at the type of scams and fraud that occur via the insiders. I was disgusted with Enron because I find white collar fraud worse than blue collar crime, yet white collar fraud conviction is padded by wealth. There should be ultimate punishments for white collar fraud…those in society that have gone to the country’s best schools and then turn around and abuse the system. Makes me sick to my stomach. I am sorry you were impacted by Enron. I don’t think the public understands how we are all impacted by fraud that is considered legal, but we all pay for it through inflation and debt.

I despised what happened with Enron, but blame myself for not looking at the actual holdings of the Janus fund, because it took some time to unfold.

That said the crookery on Wall Street and in the Board Rooms these days makes the robber barrons of the 1890s look like minor leaguers. We live in a society that totally revers someone closing down a factory, then making a bundle in the merger deal or restructuring. We allow shenanigans inside banks. Why? This society loves money more than anything else, pure and simple. That is sad. I have an old cartoon somewhere that shows an alien spacecraft and alien asking a human “take us to your leader.” The man replies he cannot do that and is not possible, but he “will gladly sell them the planet.”

We live in a time of great financial peril. All we can do is hope that some President really figures that out. Teddy Roosevelt did. Jefferson and Jackson did too.

Tincup, I love your blog. It’s right up my alley. I gave you a plug today in my own Tech Business Today blog at ITworld. Hope it helps attract more readers. If you’re inclined to identify yourself (or at least your gender!) and offer some background on your credentials, I can update my post. If not, that’s obviously your choice. (I’ve written several blogs anonymously for professional reasons.) Chris Nerney

Hi Chris. Thanks for stopping by and for your plug which was a good summary. I see that your post on Facebook IPO pump is how we got connected. I really enjoyed that article. As far as who I am and related credentials….I prefer to keep that relatively private as I enjoy the freedom to post what I think without any want of public recognition or contempt.

My other blog reveals my personal thoughts and you can learn much about me via that blog….but here a few general descriptors….male, generation X, undergraduate degree in Rhetoric, MBA finance, twelve years Fortune 500 business experience, currently member of long-term unemployed and bankrupt, Utopian dreamer and belief mankind could excel by overcoming economics as primary focus. Many of my concerns and Utopian dreams were formed before and during experience in the business world…and now I have time to write about them:)

i don’t have any specific credentials that make me an expert on the subject matter of this blog, but I know and care just enough to expose or highlight one sphere of the American construct that I believe is corrupt and fraudulent.even if it is considered legal. Excessive wealth generation via a flawed structure is tearing this country apart. The concept people don’t understand is that money represents a pie (even with printing more because it is counterbalanced with inflation) and if a few eat most of the pie there isn’t much left for the rest of us.

Congratulations on retaining your Utopian dreams after a dozen years in corporate America. That’s hard to do. While Utopias may never exist in the real world, I’d rather us aim for one and move the needle in that direction than settle for the intolerable crap we’re living with now.

As far as specific credentials for understanding what’s happening with social media IPOs and the general economy, nobody has fewer than me (longtime journalist, former stand-up comic, current musician — talk about hitting all the lucrative professions!). But, like you, I know a rigged game when I see it.